What Tax Consequences Should Startups and Investors Be Thinking About When Selling or Purchasing Convertible Notes?

Many startups sell convertible promissory notes to raise initial capital from investors, but very few startups or investors actually think about how the interest and conversion of the notes is treated for tax purposes. Understanding the federal income tax consequences to the investor, as well as the startup, can be daunting. Questions arise as to when interest has to be recognized as income by the investor, when the startup has to issue tax forms (e.g. Form 1099s) to investors, and whether investors have to recognize a gain on conversion of convertible notes.

Below are answers to the more common questions we receive concerning the tax side of convertible notes. As with almost all tax answers, we have made a few assumptions including:

• The convertible notes are sold with traditional debt terms including a fixed maturity date and interest rate;
• No payment of principal or interest payments are due until maturity; and
• The amount the investor pays for the note equals the principal amount of the note.

When Does an Investor Recognize Interest Income?

The answer is not intuitive (and may seem downright screwy) to many people in the more common circumstances. In a small minority of note financings, the notes will require regular payments (at least annually) of interest and if those payments are made timely, then the investor will recognize interest income when the interest is paid or when it accrues, depending on whether the investor uses the cash or the accrual method of accounting. Unfortunately (from a tax perspective), this is not how most convertible notes are set up.

More frequently, interest on convertible notes is not payable until the notes mature. In this situation, the note is said to have “original issue discount” or “OID,” which is required to be taken into income over the term of the note, even though payment of the interest is deferred until the note matures and even if the note holder generally uses the cash method of accounting.
Hence, the startup must issue a Form 1099-OID to each investor who holds a note that is not a corporation or other exempt payee. This can be a surprise to many investors, because they not infrequently believe they don’t need to recognize any income until the interest is actually paid (or converted into shares).

The tax basis (called in this context, the “adjusted issue price”) of the convertible note in the hands of the investor increases by the income taken into account over the term of the note, so that no additional income is recognized when the accrued interest is paid at maturity. Where a note has OID, the timing of the interest deduction for the startup corresponds to the timing of the interest income inclusions of the note holder, subject of course to the limitations on deductibility of interest imposed by the tax laws.

Illustration: Assume a startup issues convertible notes for $10,000 and that the annual interest rate is 5 percent and no interest payment is required until the note matures. Even though the company will not be making any interest payments until maturity, the investor will still be required to recognize as taxable income the interest that accrues on the note under the so-called “constant accrual method,” which calculates the interest accrual using compounding concepts. In addition, subject to applicable limitations, the company will have a corresponding interest deduction.
When payment of the principal and the interest is due at the maturity of the note, the investor’s basis in the note will have increased by the amount of interest income that it has been required to take into income over the term of the note, so that the interest will not be taxed again when it is paid.

What If Stock Received Upon Conversion of the Note Has a Value Higher Than the Principal Amount of the Note?

Most frequently, when convertible notes convert, they do so at a discount to the price of the stock sold in the financing triggering the conversion. In this case, gain is generally not recognized upon the conversion of a convertible note, even if the value of the stock received on conversion exceeds the principal amount of the loan.
However, any stock received in payment of accrued interest that has not already been included in income will be taxable. The basis of the stock to the investor will be equal to the investor’s basis in the note immediately before conversion plus the amount of any interest previously included in income. The holding period of the stock includes the period during which the investor held the note. The company issuing the note does not recognize gain on conversion, but will have interest expense for any accrued interest converted into stock, to the extent the deduction has not previously been accrued.

Illustration: Assume that on June 30, a startup converts a note that pays interest annually at the end of each year. Assume that at that point $250 of interest has accrued during the year, and the issuer issues additional shares of stock for the accrued, but unpaid, interest. The investor will receive a 1099 for year 3 reporting $250 of interest income, and the company will have a $250 deduction for interest.

What If a Note Is Sold With a Warrant?

Generally, a convertible note is considered debt until it is converted. This means that even though the convertible note is convertible into stock, the conversion feature of the note (which is treated as an option for tax purposes) is ignored in the exchange. As a consequence, for purposes of determining the holder’s basis in the note, the option (the conversion into stock) is ignored.

However, in some circumstances a startup will try to make a debt financing more attractive to investors by including a warrant to purchase shares of stock independent of any conversion of the debt. In those circumstances, an analysis needs to be completed to determine what portion of the investment needs to be allocated to the warrant.

Here is an illustration of how an investor should treat an investment in a note with warrants for tax purposes: Assume a startup sells an investor a $10,000 convertible note, and in connection with issuing the note, also issues a warrant giving the investor a right to purchase shares of common stock independent of whether or not the convertible note is converted. Also, assume that the warrant has a value at issuance of $400. (As an aside, determining the value of the warrant for tax purposes can be challenging.)

For purposes of determining the investor’s basis, the cash paid to the startup must be allocated between the note and the warrant— $9,600 will be allocated to the note and $400 to the warrant. Because the note will pay $10,000 at maturity, the $400 in excess of the basis of $9,600 will be treated as original issue discount as described above.

Keep in mind that the information and illustrations above are based on certain assumptions and address the tax consequences of very standard convertible notes; many convertible notes have far more complex features. The tax results associated with more complex notes can vary significantly, depending on the terms of the notes. Sometimes these notes call for contingent cash payments during the term of the note, and often warrants are issued together with a note as an investment unit. Premiums and discount rules may also apply.

All of these variations can affect the amount, timing and character of income and deductions associated with the transaction. If you are considering selling or purchasing convertible notes, you should discuss the specific terms of the notes with your tax adviser before committing to selling or purchasing convertible notes.